This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers, click the "Reprints" link at the bottom of any article.

October 3, 2013

PIMCO’s Gross: Look Out for Low Rates Till 2035

Investors can eke out 4% portfolio returns if they stick to front-end yields, bond manager says

In his monthly investment outlook for October, the PIMCO manager waxes theological about the cruelty of a world where sickly lion cubs become hyena food, but sees a parallel between an indifferent nature and repressively low interest rates that punish savers.

Predicting low policy rates not just for the next year or two but for decades, Gross compares the current situation to the early 1940s — “the last time the U.S. economy was this highly levered” — when 10-year Treasury rates averaged 3% less than nominal GDP for a quarter-century.

In today’s circumstances, that implies a “10-year Treasury at close to 1% and the policy rate at 25 basis points until sometime around 2035!” Gross writes, adding: “I’m not gonna stick my neck out for that – April, May and June of 2013 have taught me a lesson that low yields can become high yields almost overnight. But they should stay abnormally low.”

While Gross professes “rage and incomprehension at the pain and death of living things,” he comes to accept that government financial repression — channeling funds to itself to maintain near-zero rates — is necessary in an economy in which households can’t afford to pay higher rates.

“How high a rate can a homebuyer handle?" he asks. "The increase of over 125 basis points in a 30-year mortgage over the past 6–12 months seems to have stopped housing starts and importantly mortgage refinancings in its tracks. It was the primary ‘financial condition’ that Chairman [Ben] Bernanke cited in his September press conference that shifted the ‘taper to a tinker to a chance’ that maybe they might do something next time.”

So, while Gross says that tapering must commence at some point — “they can’t just keep adding one trillion dollars to their balance sheet every year without something negative happening” — once quantitative easing ends, rates will still remain low.

“If you want to trust one thing and one thing only, trust that once QE is gone and the policy rate becomes the focus, that fed funds will then stay lower than expected for a long, long time," Gross writes. "Right now the market (and the Fed forecasts) expects fed funds to be 1% higher by late 2015 and 1% higher still by December 2016. Bet against that.”

The reason is that yields—whether on Treasuries, mortgages or credit cards—represent the “hurdle” an economy has to overcome to grow, and the U.S. economy is just too weak to jump over much.

“We have seen a 3% Treasury yield and a 4½% 30-year mortgage rate and the economy peeked its head out its hole like a groundhog on its special day and decided to go back inside for another metaphorical six weeks. No spring or summer in sight at those yields,” Gross says.

Going forward, Gross says bond investors might optimally look forward to achieving 4% returns if they stick to “front-end yields” (i.e., short-term Treasury notes) which are stabilized by the Fed’s inability to raise rates in a levered economy. He also recommends TIPS and “the avoidance of anything compositely longer than, say, 7-10 years of maturity.”